Streetwise Professor

October 5, 2014

Damage Control at the CFTC

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 7:39 pm

The WSJ recently ran an article describing the ongoing standoff between the EU and the CFTC over swaps clearing. The Europeans have refused to certify any US clearinghouse as being subject to regulations equivalent to those under which European CCPs do. For its part, the CFTC has refused to recognize EU CCPs. The Europeans have pointedly recognized CCPs from a variety of other nations, including Japan, Hong Kong and India: things are so bad between the US and Europe that I wouldn’t be surprised if the Euros certified a North Korean CCP before they did the same for CME or another US CCP.

Failure to certify will mean that it will become prohibitively expensive for US firms to clear swaps in Europe, and vice versa. This will exacerbate the already worrisome fragmentation of swaps markets along jurisdictional lines.

The Euros are furious at the US’s rather imperialistic attitude on derivatives regulation, especially under the Gensler chairmanship of the CFTC. As new commissioner Christopher Giancarlo points out in a scathing speech delivered at the recent FIA meetings in Geneva, this imperialism was not limited to clearing issues alone. It also involved attempts to dictate how trades are executed, that is, the “Worst of Frankendodd” SEF mandate:

Making things worse, the CFTC swaps trading rules contain a host of peculiar limitations based on practices in the US futures markets that have not been adopted in the EU11 or anywhere else. Several of these peculiar CFTC swaps trading rules are contrary to common practice in global markets and are unlikely to be replicated by non-US regulators, including:

  • Trading only on order books and request for quote (RFQ) systems to TWO then THREE counterparties;12
  • Exchange-certified “made available to trade” determinations;13
  • Swap Execution Facility (SEF) position-limit maintenance and enforcement;14
  • Limitations on counterparty transparency;15 and
  • 10 CFTC Staff Advisory No. 13-69 (Nov. 14, 2013), available at

Now I have long been a critic of these rules. And so my criticism is not new and is not directed at the staff of the CFTC who worked hard to adapt existing trading models to meet greatly expedited implementation deadlines.

Here’s the key paragraph:

The avowed purpose of the CFTC’s broad assertion of jurisdiction is to insulate the United States from systemic risk. Yet, on the ostensible grounds of ring-fencing the US economy from harm, the CFTC purports to tell global swaps markets involving US persons to adopt particular CFTC trading mechanics that do almost nothing to reduce counterparty risk. In the words of one former senior CFTC advisor, the Interpretative Guidance “yoked together rules designed to reduce risk with rules designed to promote market transparency. Yet it provided almost no guidance about how to think about the extraterritorial application of market transparency rules independent of risk. As a result, [the CFTC prescribed] how to apply US rules abroad based on considerations that are tangential to the purposes of those rules.”

How do like them apples? (Those who remember the Gensler regime will know what I’m referring to.) As Giancarlo notes, a US obsession with swaps execution, that has nothing to do with reducing systemic risk, is causing jurisdictional fragmentation that likely increases systemic risk. What’s more, I would add that this is nuts even on its own terms. The idea behind SEFs was to increase competition in swaps execution. But fragmenting the market between the US and Europe reduces competition.

Giancarlo also rightly criticizes the fact that the CFTC issued an “Interpretive Guidance” and a “Staff Advisory” rather than a formal rule. In theory firms could disregard this “guidance”, but in practice that would be a very dangerous and risky thing to do. Meaning that the CFTC has effectively imposed an indefensible policy without going through the processes that are intended to mitigate policy mistakes. Unfortunately, a federal judge recently ruled against an industry legal challenge to the CFTC’s imposition of its dictates through such procedural legedermain.

Giancarlo has a concrete proposal to eliminate the impasse:

But we can go further. I intend to do everything I can to encourage the CFTC to replace its cross-border Interpretative Guidance with a formal rulemaking that recognizes outcomes-based substituted compliance for competent non-US regulatory regimes. As part of that effort, I will seek the withdrawal of the CFTC staff’s November 2013 Advisory that fails not only the letter and spirit of the “Path Forward,” but also contradicts the conceptual underpinnings of the CFTC’s Interpretive Guidance.

I hope that happens, but the question is whether it will happen in time. Unless the impasse is resolved soon, the “Balkanization” that Giancarlo laments will only get worse. Once that division becomes established, it will be difficult to reverse later, even if the the US and EU eventually recognize the equivalence of each other’s CCPs.

The good news here is that new Chair Timothy Massad also appears to be substantially less rigid, dictatorial, and imperious than his predecessor Gensler. Perhaps we shall see a more reasonable approach to derivatives regulation, especially on cross-border issues. This will not be sufficient to undo the many defects of Frankendodd, but it may at least mitigate the damage.

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  1. the use of “guidance” rather than a rule by regulators is an old trick to basically deny one’s own blame if anything goes wrong, or jump on a regulated entity when something does. i hope there is a walk back on a lot of this: It looks like Gensler tried to grab as much as he could, and then did a bolt when the resistance got too strong and the consequences in terms of work required by the regulators (and the concomitant responsibility) scared him and or the staff.

    when I was a consultant, I used to describe most in my trade as pigeons: fly in a window, deposit guano all over the place, and leave the regulars to clean up the mess as we went out the window. I think this fits Gensler.

    Comment by sotos — October 7, 2014 @ 7:09 am

  2. @sotos. You are onto Gensler. Totally. I compare him to the Sorcerer’s Apprentice.

    It’s interesting. He clearly had political ambitions, but he’s been laying low. I think he alienated many, many people. The problem is that like you said, we have to clean up the mess he left.

    The ProfessorComment by The Professor — October 7, 2014 @ 8:50 am

  3. The results in the cross-border case (SIFMA v. CFTC) are really surprising. I’m starting to think the APA Emperor Gene Scalia has no clothes (1 win against 4 losses vs the CFTC, and this case was supposed to be a slam dunk). The court did require the agency to revisit a modicum of its cost-benefit analysis. Hopefully at this point the agency will present a serious, focused, and rigorous analysis.

    Comment by Tim — October 7, 2014 @ 9:40 am

  4. @Tim-I was surprised too. It did seem like a slam dunk to me. Re Scalia, he did win one case against the SEC and the position limits case against the CFTC (although the judge did not rule on most aspects of the case that Scalia’s side raised). (Full disclosure: I submitted an affidavit in the position limits case.) It will be interesting to see how the new position limits rule fares in court, and whether an appeals court will reverse the decision in SIFMA v. CFTC.

    The ProfessorComment by The Professor — October 7, 2014 @ 12:13 pm

  5. With this D.C. Circuit? Seems unlikely. Anyway, I think it’s telling SIFMA hasn’t appealed yet.

    Comment by Tim — October 8, 2014 @ 6:57 pm

  6. There seem to be a perfectly adequate approach here: divide up cross border activities by entity domicile and regulate inter-affiliate exposures across border through capital. This is how Fed final rules on bilateral margin and Basel III capital work and how all SEC rules in securities work and the SEC draft rules for ET treatment under Dodd-Frank Title VII.

    The CFTC cannot in practice regulate all financial entities in the world and in the process of trying it is in effect driving non-US entities away from trading on a collateralized basis in the US (i.e. with minimal systemic risk). No doubt if we did enough data digging we could demonstrate this has a material detrimental effect on the US economy. The argument that this is just because the US regulated first does not hold water as EU and Japan regs for examples follow the above approach I believe.

    Why is the economic growth point lost on the debate (in DC)?


    Comment by Jon Skinner — November 4, 2014 @ 5:00 am

  7. The appeal deadline has now passed in the SIFMA cross-border case. A total loss for the banks and Scalia. It’s a shame that the party with the best lawyers gets its way in important public policy issues like this.

    Comment by Tim — November 18, 2014 @ 8:02 pm

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